Transition costs and their impact on adequacy

Vidija Pastukiene

Seminar on Private Pension ProvisionTransition costs and decumulation phaseTallinn, 6-7 September 2007

Ministry of Social Security and Labour of Lithuania

Outline of the presentation

Lithuanian pensions: main features II pillar pension reform: main features Key components of transition costs Transition costs evolution Sources for covering transition deficit Social insurance fund prognoses Replacement rates Issues under discussion

Lithuanian pensions: main features

Old age dependency ratio: 22% in 2004, 45% in 2050.

85% of labour force are insured Average pension to average wage

(gross) – 32%, net – 44% Total social insurance contribution rate

34% CR for pension insurance – 26%

II pillar pension reform: main features

Contribution rate to funded individual DC account: 2004 – 2.5%, 2005 – 3.5%, 2006 – 4.5%, 2007 – 5.5% out of existing social security contribution rate for old age pension insurance (21%)

Participation voluntary for everybody insured under retirement age but no switching back

Benefits available from legal retirement age, compulsory annuity with floor and ceiling

Heritage of pension assets Benefits non taxed No central guarantee fund nor explicit state

guarantees

Key components of transition costs

Each year the size of the transitional deficit is calculated by the following equation:

Transitional deficit (year) = A – B A = flow of contributions into the second

pillar B = reduction in PAYG expenditures as the

result of introduction of the second pillar

Key components of transition costs

1. Flow of contributions into the second pillar depends on:

Contribution rate to funded pillar (2.5%-5.5%) Participation rate evolution (from 55% in 2005 to

75% in 2050) Income level of participants Economy real wage growth (sharp changes up

to 20% recently)

Key components of transition costs

2. Reduction in PAYG expenditures as the result of introduction of the second pillar depends on:

difference in CR diverted to supplementary part of PAYG pension (10.5 in 2006) and CR diverted to II pillar (5.5 from 2007)

fraction of pensioners getting benefits from funded component (8% in 2008, 58% in 2030 and 75% in 2050)

RR of PAYG component (32.5%, constant due to pension indexation to wages)

Transition costs evolution

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

Contributions into the II pillar Reduction in PAYG expenditures Transition costs

Sources for covering transition deficit

Social insurance fund surplus (available until 2020)

Privatization fund assets Transfers from state budget Parametric reforms of current pension

system (increase in retirement age to 65 from 2012 to 2026 is under consideration )

Social pension insurance fund surplus (available until 2020)

-2.50%

-2.00%

-1.50%

-1.00%

-0.50%0.00%

0.50%

1.00%

1.50%

2.00%

2005

2008

2011

2014

2017

2020

2023

2026

2029

2032

2035

2038

2041

2044

2047

2050

SSI Fund Budget without transfers from state budget

SSI Fund Budget with transfers from state budget (50%)

SSI Fund Budget without reform

SSI Fund Budget RA(65,65)

Past trend and nearest prognosis of transition costs

0

0.2

0.4

0.6

0.8

1

1.2

2004 (2.5%)

2006(4.5%)

2008(5.5%)

prognosis

2010(5.5%)

prognosis

Contributions to second pillar as % of GDP

Transfers from State Reserve (Stabilization fund)

Replacement rates

0%

5%

10%

15%

20%

25%

30%

35%

40%

Mono-pillar system Two-pillar system: total

Two-pillar system: first pillar Two-pillar system: second pillar

Replacement rates

RR in PAYG mono-pillar system (32.5%) is constant all projection period due to assumed pension indexation to wages (there is no automatic indexation rules in the Law)

The diversification of pension sources and reduction of PAYG program (8.8 % lower replacement rate) will reduce the expenditures of social insurance fund by 0.6% GDP in the end of transition period in 2050.

Due to projected higher real rate of return of funded part switchers of two pillar system are projected to get higher replacement rate by 2 percentage points

Issues under discussion

Financing of transition costs is agreed annually while composing social insurance and state budgets. So far it is shared 50/50 by both.

There are proposals to increase contribution rate up to 10% by 2010. This could lead to enlarging of transition burden to 1.8 % GDP

Social insurance fund expenditure projections

0%

1%

2%

3%

4%

5%

6%

CR=5.5% CR=10% Without reform RA (65,65)

Thank you for your attention!